Prohibitions have been eroding slowly, and the door to hedge-fund-like
expenses is now open

Boy,
what a difference 25 years makes in the world of fund taxation. When my
firm launched the first long/short fund in 1986, we had to contend with
several constraints: the “short short” rule, which I will explain in a
moment, a limitation on shorting stocks, a severe limitation on the use
of futures and a prohibition on incentive-based fees.

Over
time and congressional bending, 70 friendly Internal Revenue Service
rulings and some financial engineering, these rules no longer seem to
matter. And more changes may be coming.

First, a little history.

The
Revenue Act of 1936 established that regulated investment companies,
more commonly known as mutual funds, must pass certain tests in order
to escape being taxed like regular corporations. If the fund flunked
one of the tests, a full corporate tax would be levied.

Sen.
Carl Levin, D-Mich., in his recent effort to curtail the use of
offshore entities, reminded us of that when he said that the act's
Section 851(b)(2) “restricts the types of income that mutual funds are
allowed to obtain in exchange for favorable tax treatment.”

In
the past, a “short short” rule applied to mutual funds, which said that
no more than 30% of a fund's income could come from transactions that
lasted for less than three months. The Tax Reform Act of 1997 repealed
that rule.

The
1936 Act also required mutual funds to garner most of their profits
from securities. But that limitation has been tested, as well.

Investing in commodities indexes blossomed in the 1990s, and a few commodities mutual funds were
offered. Because futures aren't securities, the funds got their
commodities exposure by investing in swaps tied to commodities (or
commodities indexes).

The
fund's cash was kept idle as collateral for the swaps. All went well
until Revenue Ruling 2006-1 stated that the funds had to look through
the swaps to the underlying reference asset to see if those assets were
securities.

The ruling inferred that notes (debt) tied to commodities wouldn't be
looked through and that commodities-linked debt would be counted as an
eligible security, throwing off “good income” instead of a swap's “bad
income.”

In
order to be treated as debt, notes must have a reasonable return of
principal feature and not be a derivative. Soon after Rydex Funds
received a private-letter ruling from the IRS approving its offerings,
others followed suit.

The note structure forced funds to assume an increased counterparty credit risk for each issuer.

Developers
of managed-futures mutual funds conceived the idea of using a “blocker”
corporation headquartered in a tax haven country. The government
permits these so-called blockers when tax- exempt institutions use them
to invest in leveraged hedge funds, so why couldn't mutual funds invest
in a wholly owned offshore corporation that could invest as it chose in
futures, and turn “bad” income into “good” income?

More
than 40 IRS private rulings were issued that blessed funds using
controlled foreign corporations, and as long as a mutual fund invests
in a security — in this case, the common stock of the CFC — it is
OK.

Fund
creators must have concluded that since CFCs can be used this way,
wouldn't it be possible for an offshore CFC to charge a pure incentive
fee, too?

Since
their inception, domestic funds have been prohibited from charging an
incentive fee in the form of an uncapped percentage of profits. But
through a CFC, which would invest with commodities-trading advisors
that charge a percentage of profits, the incentivized compensation
would occur in the CFC, not
the fund itself.

That
has been happening in several managed-futures funds, and there is some
concern in Washington as to how these funds are reporting the “true and
total” fees that investors are paying. I suspect that between Mr.
Levin's rumblings about tax issues, the regulatory discomfort with fee
disclosure and a move by the Commodity Futures Trading Commission
toward rethinking fund manager regulation, these funds will have to
morph again.

If
the situation remains unchanged, the mutual fund world is likely to be
deluged by hedge fund managers who don't lift a finger unless they get
a cut of the profits, and have never contemplated operating a fund.
Their arrival wouldn't necessarily be unwelcome, but we need to know
what the rules are.

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articles are provided for
information purposes only. They are not intended to be an
offer to engage in any securities transactions or to provide
specific financial, legal or tax advice. Articles may have been
rendered partly inaccurate by events that have occurred since
publication. Investors should consult their advisers before
acting on any topics discussed herein.